The mould for shaping the much anticipated and elusive implementation of General Anti Avoidance Rules (GAAR) has been set by the government by issuing the draft guidelines. The draft guidelines shed a practical light on the directions and reasoning (in the form of illustrations) for invoking the provisions of GAAR by the tax officer.

The message behind these norms is that the future transaction/investment structuring / reorganisations would all have to pass the test of GAAR, with the draft guidelines forming a stepping stone towards its implementation. The draft guidelines have attempted to lay out a pathway as to what would be considered permissible/impermissible to avoid indiscriminate application. The committee has invited comments/suggestions on the draft guidelines by July 20.

Highlights of the proposals in the draft guidelines:

It is proposed to enact GAAR prospectively i.e. on or after 01.04.2013. This should provide some relief for the past transactions.

It has been clarified that in case only a part of the arrangement has resulted in a tax benefit, then the GAAR provisions would be attracted only to that part and not the whole transaction.

GAAR to be invoked for tax benefits exceeding a specified monetary limit

A time-bound procedure for invoking GAAR has been charted in the form of statutory forms to be used by the tax officers for building in adequate safeguards and transparency

Foreign Institutional Investors (FIIs) and the non-resident investors would not be subject to GAAR, in case, the FII pays tax under domestic tax laws of India if it does not avail the treaty benefits. In case tax treaty benefits are claimed, GAAR provisions may be invoked in the case of the FIIs. In any case, GAAR provisions would not be invoked in the case of non-resident investors of the FII.

When can GAAR be invoked?

GAAR can be invoked if there is a tax benefit (reduction/avoidance/deferral in tax or reduction in total income / increase in loss) and creates rights or obligations (not at arm’s length)/misuse of tax law/lacks commercial substance/not for bonafide purpose.

The onus is on the tax officer to prove the tax benefit arising out of a transaction. In case, GAAR is attracted, the whole transaction could be disregarded or re-characterised.

Setting an example

It is interesting to note a few illustrations in the guidelines, depicting key areas of transactions subject to GAAR, which may impact the current investment / transaction pattern by the private equity and the corporate houses:

Inbound investments

Commercial substance in a low tax jurisdiction

A company set up in a low tax jurisdiction and carrying on business with adequate manpower, capital and infrastructure and conducting board meetings would not be subject to GAAR in light of adequate substance.

This should instil confidence in the private equity fund houses that are able to meet adequate substance. However, it is unclear on the nature of business to be carried on for establishment of substance.

Exit scenario – capital gains

Scenario 1: Beneficial ownership

Investors situated in overseas jurisdiction set up a pooling vehicle for funds in an intermediate jurisdiction and such intermediate company further makes downstream investment in India (with no other transaction).

The beneficial ownership vests with the overseas investors.

Such intermediate company claiming capital gains tax exemption at the time of sale of shares of India Portfolio Company under the Treaty would be disregarded.

Beneficial ownership of the funds invested in India would be considered as the real owner at the time of exit from India. Existing funds having a similar investment pattern i.e. low tax jurisdiction investment need to re-evaluate the investment structure.

Scenario 2: Interposing intermediate holding company

GAAR would be attracted in the following cases involving cases where intermediate jurisdiction is interposed for making investments in India:

Capital gains on sale of shares of an Indian company by A (intermediate jurisdiction), where A is a “permitted transferee” of its parent Y (overseas jurisdiction) i.e. although shares are held by A, all rights of voting, management, right to sell, etc. are vested in Y.

Interest on borrowings

Funds are raised by company by way of borrowings instead of equity

The decision of debt vis-a-vis equity is a commercial decision and in the absence of thin capitalisation norms and interest payments, GAAR would not be attracted

However, interest paid to connected parties (associated enterprise/related parties/relative) in low tax jurisdiction could be subject to GAAR

Arrangement of subscription to Compulsorily Convertible Debentures may need to be revisited in light of the above clarification.

Merger of loss making company into a profit making company

The losses off set against the profits in this case would result in lower taxability.

GAAR would not be attracted since adequate mechanism has been built in the merger provisions.

Reorganisations carried out by companies for alignment of value in the group entities would not be impacted in this case.

Overseas dividend not repatriated to India

Dividend earned by the overseas holding company (set up by an Indian Co) from its WOS and not repatriated to India would not be subject to GAAR, as declaration of dividend is a business reason. Further, Controlled Finance Company (CFC) regulations would address the taxability.

This is a welcome clarification for corporate houses having overseas business with future investments out of the retained earnings at overseas level.

The existing investment framework of the private equity funds and the transactions undertaken by the PE deal makers and the Indian corporate houses could come under the GAAR scanner in case of lack of substance. The exit and funding strategies, current investment framework and the holding company jurisdiction structure need to be evaluated by the investors taking cue from the draft guidelines.

The draft guidelines aims to set up a stage for the deal makers to keenly watch out the commercial substance and the business rationale before undertaking a transaction.